May 2018 Understanding $25 par value preferred securities

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1 May 2018 Understanding $25 par value preferred securities In today s market environment, preferred securities appear attractive for their current yields and a history of lower sensitivity to rising interest rates. The more than $500 billion U.S. preferred securities market is divided into $25 and $1000 par securities. 1 Exchange-Traded Funds (ETFs), which often contain predominantly $25 par securities, are an increasingly popular way to access the preferred securities market. However, these securities often trade at a negative yield-to-call and have a lower proportion of securities that have coupons with reset features. TWO PREFERRED SECURITIES MARKETS EXIST The U.S. preferred securities market is divided into two distinct markets: $25 PAR SECURITIES typically trade on the New York Stock Exchange and are favored by retail investors for their small denomination. $1000 PAR SECURITIES trade overthe-counter and are purchased mainly by institutional investors. Companies that issue preferred securities will often issue both $25 par and $1000 par structures to diversify their investor bases. Retail investor behavior can often make the $25 par market more volatile than the $1000 par value market because retail investors may bid up the price of $25 par securities in their search for yield. Most ETFs are passively managed to mirror a benchmark index that often consists of predominately $25 par preferred securities because they: Offer daily liquidity Provide price transparency Were created when $25 par securities comprised the majority of the U.S. preferred security market 1 NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE

2 Large ETFs hold a high percentage of $25 par securities PowerShares (PGF) % $25 par preferreds PowerShares (PGX) 89.4 ishares (PFF) Data source: Bloomberg, L.P., 31 Mar Past performance is no guarantee of future results. Based on three largest ETFs in Morningstar Preferred Stock category, which constitute 98.3% of the category assets. $25 PAR SECURITIES MAY HAVE A NEGATIVE YIELD-TO-CALL While preferred securities are typically perpetual, most of the universe has explicitly stated call provisions. A call provision allows the issuer to repurchase and retire the security at a specific price within a designated time period. Most preferred issuers will call securities when they can be refinanced at cheaper levels. This is usually in response to lower interest rates, tighter credit spreads or excess capital carried on the issuer s balance sheet. 2 When a preferred security is trading at a premium, or above its par value, it is valued using yield-to-call. 3 Yield-to-call is the bond s yield if it was bought and held until its call date. When the premium is high enough, the bond can actually have a negative yield-to-call. If an issuer calls a security trading at a negative yield-to-call, the investor will experience a loss. Retail investors are often unaware of the call feature. Further, they may not understand yieldto-call and simply focus on the security s coupon rate. During periods of prolonged low interest rates, retail investors may bid up the prices of $25 par securities as they search for higher coupons. Preferred securities issued with higher coupon rates can appear especially attractive when rates are historically low, as they have been since the credit crisis. However, these tend to be the structures that issuers are most likely to redeem by exercising the call option. Thus these securities are more likely to generate negative yield-to-call within today s $25 par market. Valuations for retail $25 par securities recently became so high that a significant population of securities have been trading at a negative yield-to-call. This illustrates the irrational retail pricing that may occur as investors seek higher coupon securities without fully understanding bond pricing. This irrational exuberance also gives issuers the opportunity to place new issue $25 par preferreds at attractive levels. Negative yields-to-call typically do not occur in the institutionally dominated $1000 par preferred market. Institutional investors have greater resources and tend to look at valuations from a more holistic perspective, rather than simply focusing on income. For example, in April 2013, J.P. Morgan called eight different $25 par preferreds, totaling more than $5 billion par. All eight securities were trading at premiums, with seven resulting in substantial investor losses. In 2016, eight more $25 par securities trading with a negative yieldto-call were redeemed. This also resulted in substantial investor losses. Sample scheduled call losses Ticker Call date Price prior to call Realized yield-to-call (%) Size of deal ($mm) BCS C 9 May ,150 CFC A 13 Jul BAC Z 13 Jul MER M 13 Jul MWR 19 Jul MWG 19 Jul MWO 19 Jul MSK 19 Jul Data source: Bloomberg, L.P. Past performance is no guarantee of future results. Realized yield-to-call is annualized. Securities mentioned are used as examples for educational/informational purposes only; inclusion here does not constitute a recommendation to buy or sell nor imply inclusion in any Nuveen investment vehicle. 2

3 We believe managing call risk should be a high priority for preferred investors. However, passively managed ETFs with a mandate to match benchmark returns do not have the flexibility to manage this risk. As a matter of fact, pursuing alpha will create dispersion from the index s returns for these types of ETFs. $25 par is predominantly fixed coupon exposure As a result, many ETFs are heavily invested in preferred securities trading at a negative yieldto-call. Should the issuers actually call these securities, the value of the overall portfolio would decline. 4 2 $1000 par Coupons with reset features 4 CoCos Fixed rate coupon 19 $25 par Major ETFs have held a high percentage of negative yield-to-call securities 25% 2 15% Data source: Bloomberg, L.P., 31 Mar Representative indexes: $1000 par : market capitalization-weighted blend of the ICE BofA Merrill Lynch U.S. Investment Grade Institutional Capital Securities Index and the ICE BofA Merrill Lynch U.S. High Yield Institutional Capital Securities Index; Contingent Capital (CoCo): ICE BofA Merrill Lynch Contingent Capital Index; $25 par : ICE BofA Merrill Lynch Core Plus Fixed Rate Preferred Index. It is not possible to invest in an index. COUPONS WITH RESET FEATURES HAVE LESS RATE SENSITIVITY 1 5% PowerShares (PGF) PowerShares (PGX) % Securities with negative yield-to-call ishares (PFF) Securities that have coupons with reset features tend to be less sensitive to rising rates compared to those with traditional fixed rate coupon structures. A common reset structure over the past several years is the fixed-to-floating rate coupon security. Data source: Bloomberg, L.P., 31 Mar Past performance is no guarantee of future results. Data represents the three largest ETFs in the Morningstar Preferred Stock category, which constitute 98.3% of the category assets. FEWER COUPONS WITH RESET FEATURES EXIST The typical coupon structure of $25 par preferred securities market also differs from that of $1000 par securities. A vast majority of the $25 par market is composed of traditional, fixed rate coupon structures. However, the $1000 par market contains a variety of coupon structures, typically with a coupon reset feature. Securities with resettable coupons include floating rate, fixed-to-floating rate and fixed-to-fixed coupon structures. Fixed-to-floating rate coupon security structures often contain the following features: Pay a fixed coupon for a preset number of years (commonly 5 or 10 years) then convert to a floating rate for the remaining life of the security. The floating-rate coupon is based on a benchmark rate, such as 3-month LIBOR, plus a predetermined spread that is set when the security is issued. Compared to fixed-for-life structures, fixed-tofloating rate coupon structures experience less extension of duration when interest rates rise. This feature makes them relatively less sensitive to rate changes in a rising rate environment. They usually experience better relative price performance, since the prices of lower duration 3

4 bonds are less affected by rising rates. Lastly, the floating-rate nature of the coupon allows the securities to capture increases in interest rates, because the coupon should increase with interest rates. ETFs tend to hold more $25 par securities and fewer $1000 par securities, so they generally have more fixed rate coupon structures than other types of portfolios. This can make them more sensitive to rising interest rates, all other things equal. Securities with fixed-to-floating rate coupons remain less sensitive to interest rate changes......and experience smaller price declines when rates rise 4.5 Current Interest Rate Level bps Rate Increase bps Rate Increase bps Rate Increase Effective duration (years) Fixed-for-life coupon example Fixed-to-floating rate coupon example Current Interest Rate Level bps Rate Increase 200 bps Rate Increase bps Rate Increase Price change (%) Fixed-for-life coupon example Fixed-to-floating rate coupon example Data sources: Bloomberg, L.P. and The Yield Book, 31 Mar Past performance is no guarantee of future results. Compares the Citigroup 6.125% fixed-to-floating rate coupon to the Citigroup 6.3% fixed-rate coupon. Assumes immediate parallel shift of the 31 Mar 2018 yield curve with OAS and volatility held constant. This hypothetical scenario is for informational purposes only. Scenario data is provided by a third-party source believed to be reliable. Securities mentioned are used as examples for educational/informational purposes only; inclusion does not constitute a recommendation to buy or sell nor imply inclusion in any Nuveen investment vehicle. Major ETFs hold a larger percentage of fixed-rate coupon structures PowerShares (PGF) PowerShares (PGX) % $25 par preferreds % Fixed rate coupon ishares (PFF) Data source: Bloomberg, L.P., 31 Mar Based on three largest ETFs in Morningstar Preferred Stock category, which constitute 98.3% of the category assets. MISPRICING OCCURS BETWEEN $25 AND $1000 PAR VALUE ISSUES Beyond the limitations of negative yield-to-call and more fixed-rate coupon securities, focusing solely on the $25 par value of the preferred market reduces alpha opportunities. Active managers may have the opportunity to add value just by evaluating the pricing variations between $25 and $1000 par securities. Pricing discrepancies often occur between the two preferred markets. For example, a company may issue both $25 and $1000 par securities with identical structural features. A professional manager can compare the difference in valuations for essentially the same security, selling what they believe to be the overpriced security and buying the underpriced security. In some cases, the difference in valuations may be substantial. The two securities in the table below are identical except for the par denomination and a two basis point difference in coupon. Retail investors often focus on coupon when valuing securities, and in this case they drove the $25 par securities to relatively rich levels in their search for income. Institutional investors tend to value securities based on yield spreads versus U.S. Treasuries or senior debt. The result was an extreme difference in valuations between the two securities. An investor could have paid 3% less for the 4

5 institutional $1000 par securities and gained 68 basis points in yield versus the same structure in a $25 par security. Retail and institutional investors value preferred securities from the same company differently Issue type Retail Institutional Par $25 $1000 Coupon 5.85% 5.9 Price (% of Par) 104.6% 102. Yield-to-Call 4.83% 5.51% First Call Date 9/15/23 6/15/24 Coupon Reset 3mLIBOR +309 bps 3mLIBOR +311 bps Payments Non-cumulative Non-cumulative Maturity Perpetual Perpetual Rating Baa2/BBB Baa2/BBB Data source: Bloomberg, L.P., 31 Mar Past performance is no guarantee of future results. Compares two Wells Fargo issues. Securities mentioned are used as examples for educational/information purposes only; inclusion here does not constitute a recommendation to buy or sell nor imply inclusion in any Nuveen investment vehicle. $1000 PAR MARKET REMAINS MORE ATTRACTIVE We continue to find the $1000 par side of the market and contingent capital securities more attractive because they offer better relative value and the opportunity to reduce interest rate risk. Both the $1000 par side of the market and contingent capital securities continue to be significantly cheaper than the $25 par side of the market on a yield and spread basis. The yield to worst of $25 par securities was 2.96% lower than that of $1000 par securities and contingent capital securities, and the option-adjusted spread was actually negative. Retail investors and passive ETF demand for $25 par value securities created this pricing distortion. Retail investors have historically demonstrated a strong bias for incomegenerating investments, but cannot always appropriately value securities. They have often been purchasing the retail-sized denominations of $25 par preferred securities based on their high coupon rates alone. As a result, they have driven up the prices of these securities and their yields have declined. In addition, most passive, preferred-security ETFs only purchase the $25 par value, exchanged-traded securities. As demand for income generating ETFs has $25 par securities are expensive on many metrics Yield-to-worst (%) Lower yield $1000 par CoCos 1.93 $25 par Less spread 218 $1000 par increased, the passive, preferred-security ETFs have also purchased large amounts of $25 par value securities, driving yields down as prices rise. We also tend to prefer the $1000 side of the preferred market and contingent capital securities because they contain a greater number of securities with coupon structures that have reset features. The Fed has started to increase short-term rates, and market rates have been rising. These structures reduce duration extension risk when rates rise. ETFs MAY MISS OPPORTUNITIES 330 CoCos ETFs focusing solely on the $25 par preferred market have several disadvantages. First, many $25 par securities are currently trading at a negative yield-to-call, which may result in losses to investors if the securities are called by the issuers. Reduced availability of coupon structures with reset features in the $25 par market inherently increases sensitivity to rising interest rates, all else equal. Finally, most preferred ETFs cannot take advantage of the pricing discrepancies between the $25 and $1000 par markets due to their passive natures. As a result, ETFs leave meaningful alpha opportunities unexploited for their investors. $25 par Data source: ICE BofA Merrill Lynch; Nuveen Asset Management, 31 Mar Past performance does not guarantee future results. Representative indexes: $1000 Par Market: market capitalizationweighted blend of the ICE BofA Merrill Lynch U.S. Investment Grade Institutional Capital Securities Index and the ICE BofA Merrill Lynch U.S. High Yield Institutional Capital Securities Index; Contingent Capital (CoCo): ICE BofA Merrill Lynch Contingent Capital Index; $25 Par Market: ICE BofA Merrill Lynch Core Plus Fixed Rate Preferred Index. Investors cannot invest in an index. -80 Option-adjusted spread vs Treasuires (bps) 5

6 For more information, please visit us at nuveen.com. 6 1 Data source: Stifel, 30 Sep $50, $75, and $100 par securities exist, but they are much less common than $25 par. 2 The general underlying assumption is that if a callable security is trading at a premium, the coupon rate is above the market interest rate for that issuer, and it would be beneficial for the issuer to redeem the security and refinance it with a lower coupon structure. On the contrary, a callable security trading at a discount, or below its par value, likely has a coupon that is below the market interest rate for the issuer, and as a result, it would be beneficial for the issuer to keep the security outstanding. 3 Yield-to-call is used to value callable securities trading at a premium. Yield-to-maturity or yield-to-perpetual is used if the security is trading at a discount. The lower of these two yields is generally known as the yield-to-worst. 4 Includes floating rate, fixed-to-floating rate and fixed-to-fixed rate coupon securities. Fixed-to-floating rate securities pay a fixed coupon for a set number of years, then convert to a variable coupon for the remaining life of the security that is based on a benchmark rate, such as the 3-month LIBOR. Fixed-to-fixed rate securities step from one fixed rate to another based on a schedule. Glossary A basis point is a unit for measuring a bond s yield that is equal to 1/100th of 1% of yield. 100 basis points = 1%. A call provision allows the original bond issuer to repurchase and retire the bond within a specific time window and price to be paid to bondholders. Callable bonds will pay a higher yield than comparable non-callable bonds. The coupon is the interest rate stated on a bond when it s issued. ICE BofA Merrill Lynch U.S. Investment Grade Institutional Capital Securities Index tracks the performance of US dollar denominated investment grade hybrid capital corporate and preferred securities publicly issued in the US domestic market. The index only includes securities with deferrable coupons issued in $1,000 par format with at least $250 million face amount outstanding. ICE BofA Merrill Lynch U.S. High Yield Institutional Capital Securities Index tracks the performance of US dollar denominated subinvestment grade hybrid capital corporate and preferred securities publicly issued in the US domestic market. The index only includes securities with deferrable coupons issued in $1,000 par format with at least $250 million face amount outstanding. ICE BofA Merrill Lynch Contingent Capital Index tracks the performance of all contingent capital debt publicly issued in the major domestic and Eurobond markets, including investment-grade and sub-investment-grade issues. ICE BofA Merrill Lynch Core Plus Fixed Rate Preferred Index ICE tracks the performance of fixed rate US dollar denominated preferred securities issued in the US domestic market. Qualifying securities must be rated at least B3 and must have an investment grade rated country of risk. Yield to call is the yield of a bond or note if you were to buy and hold the security until the call date, but this yield is valid only if the security is called prior to maturity. The calculation of yield to call is based on the coupon rate, the length of time to the call date and the market price. This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor s objectives and circumstances and in consultation with his or her advisors. A word on risk This information represents the opinion of Nuveen Asset Management, LLC and is not intended to be a forecast of future events and this is no guarantee of any future result. It is not intended to provide specific advice and should not be considered investment advice of any kind. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell specific securities or investment products. All investments carry a certain degree of risk, including possible loss principal and there is no assurance that an investment will provide positive performance over any period of time. Debt or fixed income securities, are subject to market risk, credit risk, interest rate risk, derivatives risk, illiquid securities risk, concentration risk, non-diversification risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Preferred securities are subordinate to bonds and other debt instruments in a company s capital structure and therefore are subject to greater credit risk. Certain types of preferred or debt securities with special loss absorption provisions, such as contingent capital securities (CoCos), may be or become so subordinated that they present risks equivalent to, or in some cases even greater than, the same company s common stock. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. CFA and Chartered Financial Analyst are registered trademarks owned by CFA Institute. Nuveen Asset Management, a registered investment adviser, is an affiliate of Nuveen, LLC. Nuveen 730 Third Avenue New York, NY nuveen.com GRE-NPARPRF-0518P INV-AN-05/ _ 0318